Words from the wise for the week that was (Dec 31, 2007 – Jan 6, 2008)

A trading week made up of a bit of the old year and a bit of the new caused some anxiety in financial markets as economic woes escalated and weighed on investor sentiment. The problems related to the housing market and the subprime implosion seemed to be coming to a head. After all, the Dow Jones Industrial Index recorded its worst three-day start to a New Year year since the depths of depression in 1932, according to Barron’s.

Stock markets were left in the shade as both gold and oil hit all-time highs. Nouriel Roubini, professor of economics at New York University, wrote on his blog: “… the stock market started the year with another bearish fall … a lousy stock market in 2007 will look good compared to an awful stock market in 2008.”

Santa Claus failed to call upon the traders on Wall Street. The “Santa Claus Rally”, as defined in the Stock Trader’s Almanac, is the propensity for the S&P 500 Index to rally during the last five trading days of December and the first two of January. This year’s Rally saw the S&P 500 Index down 2.5% and the Dow Jones Industrial Index (-2.9%) and the Nasdaq Composite Index (-3.3%) were not spared either.

It is pointed out by the Stock Trader’s Almanac that the lack of a rally had often been “a harbinger of a sizable correction or a bear market in the coming year.” Hence the saying: “If Santa Claus should fail to call; bears may come to Broad & Wall.”

John Mauldin, author of the Thoughts from the Frontline newsletter, is also of the opinion that the equities bull market may finally succumb in 2008, and said in his 2008 forecast: “I think that we are in a recession for most of the first half of this year, and that we begin a slow recovery in the second half. It will be a Muddle Through Economy for at least another year after that. That would suggest that most companies will come under serious earnings pressure. If history is any indicator, that means we should see a bear market in the first half of this year. How deep will depend on how fast the Fed cuts, but I don’t think we are looking at anything close to the bear market of 2000-2001. Still, I wouldn’t want to stand in front of a bear market train.”

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance chart.

Economy
The past week’s economic reports fueled concerns about the spillover effect of the subprime crisis leading to an economic recession.

The much anticipated US employment report on Friday, which showed weaker-than-expected job growth and a rise in the unemployment rate, compounded investors’ worries.

According to the Institute for Supply Management, national manufacturing activity shrank unexpectedly in December. Specifically, the ISM Index fell to 47.7 from 50.8 in November – a reading below 50 indicates a contraction in manufacturing activity.

These reports provide strong support for further Fed easing. An interest rate cut of 25 basis points at the FOMC’s next meeting on January 30 seems a foregone conclusion, but the Fed Fund futures now also indicate a 46% chance of a 50 basis point reduction. “There are those who hope that the Fed will ride to the rescue with more rate cuts. I believe they will, but it is a case of ‘too little, too late’,” remarked John Mauldin.

WEEK’S ECONOMIC REPORTS

Date	Time (ET)	Statistic	For	Actual	Briefing Forecast	Market Expects	Prior
Jan 2	10:00 AM	Construction Spending	Nov	0.1%	-0.3%	-0.4%	-0.4%
Jan 2	10:00 AM	ISM Index	Dec	47.7	52.0	50.5	50.8
Jan 2	2:00 PM	FOMC Minutes	Dec 11	-	-	-	-
Jan 3	12:00 AM	Auto Sales	Dec	-	5.4M	5.5M	5.6M
Jan 3	12:00 AM	Truck Sales	Dec	-	7.0M	6.8M	6.8M
Jan 3	8:15 AM	ADP Employment	Dec	40K	-	-	173K
Jan 3	8:30 AM	Initial Claims	12/29	336K	340K	-	357K
Jan 3	10:00 AM	Factory Orders	Nov	1.5%	1.0%	1.0%	0.7%
Jan 3	10:32 AM	Crude Inventories	12/28	-4056K	NA	NA	-3299K
Jan 4	12:00 AM	Auto Sales	Dec	5.2M	5.4M	5.5M	5.6M
Jan 4	12:00 AM	Truck Sales	Dec	7.1M	7.0M	6.8M	6.8M
Jan 4	8:30 AM	Nonfarm Payrolls	Dec	18K	75K	70K	115K
Jan 4	8:30 AM	Unemployment Rate	Dec	5.0%	4.8%	4.8%	4.7%
Jan 4	8:30 AM	Hourly Earnings	Dec	0.4%	0.3%	0.3%	0.4%
Jan 4	8:30 AM	Average Workweek	Dec	33.8	33.8	33.8	33.8
Jan 4	10:00 AM	ISM Services	Dec	53.9	53.0	53.5	54.1

Source: Yahoo Finance, January 4, 2007.

The next week’s economic highlights, courtesy of Northern Trust, include the following:

•

International Trade (Jan 11) – Higher imported oil prices probably played a role in the widening of the trade gap to $58.5 billion in November from $57.8 billion in October. Exports are predicted to have risen largely due to a weak dollar, while imports are not likely to show impressive growth due to soft economic conditions. Inflation adjusted exports of goods and services grew at an annual rate of 19.1% in the third quarter, while inflation adjusted imports of goods and services posted a paltry gain of 4.4%. Consensus: $58.5 billion

•

Other reports – Pending Home Sales (Jan 8), and Import Prices (Jan 11).

Markets
The performance chart obtained from the Wall Street Journal Online indicates how different global markets fared during the past week.

Source: Wall Street Journal Online, January 6, 2007.

As this article deals only with the past week’s performance, a separate performance review of 2007’s market movements was posted on the blog last week. This round-up makes for interesting reading and also provides pointers of what to expect in the year ahead. Please click here for full the article.

Global stock markets began the year on shaky ground, trading lower during the past week amid escalating concerns about the fallout in the housing and credit markets. The MSCI World Index lost 3.2% during the course of the week, but a number of emerging markets helped to stem the overall losses.

The US markets were at the forefront of the sell-off with the blue-chip Dow Jones Industrial Index losing 4.2%, the broader S&P 500 Index 4.5% and the technology-heavy Nasdaq Composite Index 6.3%. Small caps and the sectors for REITS, financials, housing and consumer discretionary spending, in particular, were not spared the selling pressure.

Government bond yields declined in both developed and emerging markets as the global economic outlook worsened and investors switched stocks to what is perceived to be a safe-haven asset class.

On the currency front, the US dollar came under renewed pressure as markets started pricing in the possibility of the Fed reducing interest rates by 50 basis points at the end of January. Concerns about the deteriorating prospects for the UK economy resulted in the British pound recording a four-year low against the euro.

The star performers among the major currencies were the Japanese yen (+4.1%) and Swiss Franc (+2.0%) as increased risk aversion resulted in unwinding of carry trades. The Chinese yuan also caught the limelight on the back of its uptrend (as reported in the “quotes section” below).

Commodities were the big winners during the past week as investors piled into oil and precious metals.

Crude oil hit a record level of $100 a barrel early in the New Year, but subsequently eased back somewhat. Factors driving the oil price included a weaker dollar, geo-political tensions over the Middle East and supply concerns.

The gold price also reached a record high during the past week, soaring above the $850 an ounce level last achieved in January 1980. In addition to the factors driving the oil price, gold benefited strongly from mounting inflation jitters.

Agricultural commodities again put in a strong performance and gained 3.6% during the week.

This week promises to be a key week for the direction of financial markets. Hopefully the words (and graphs) from the investment wise below will assist in guiding us through the stormy waters and making the correct investment decisions. But firstly, to cheer you up, here is nature’s way of saying “have a nice day!”.

Hat tip: Jim Sinclair’s Mineset

Financial Times (Alphaville): Marc Faber – when surrounded by rubbish and danger, buy gold
“‘The credit bubble is just beginning to unwind, and while US borrowers are being blamed for the mess, they were really just a pawn in a global game.’ So says Marc Faber, aka Dr Doom.

“In the New Year issue of his Gloomboomdoom.com monthly market commentary for subscribers, Faber muses darkly on the direction of the US economy, markets, bond insurers and Wall Street banks, and concludes – as he has increasingly in the past months – that gold, among other commodities, is a very good place to put your money.

In the US, the severity of the housing recession is evident from the record level of existing home inventories as a percentage of US households, he notes. ‘It should therefore, only be a matter of time until housing starts decline further and will also signal the onset of a recession.’

“He sets out three key observations:

1)	I have never experienced a bull market in equities without the participation of financial stocks. In addition, when financial stocks across the board collapse it is a very negative sign for the overall health of the stock market.
2)	The fact that a stock has declined from the peak by 50% or even 90% does not make it necessarily inexpensive. In 1985, I recommended the purchase of a basket of Texas banks, which at the time had declined by 95% from the peak, as a contrarian play. Subsequently, they all went bankrupt.
3)	As I have explained before, the financial sector has become disproportionally large over the last 15 years or so. Therefore, I would also expect the reversion to the mean of the financial sector to take several years and not to be completed in just six months! In short, I would avoid purchasing financial stocks for now and would also defer new commitments to equities.

“Emerging stock markets are definitely to be avoided, he adds, ‘following their significant out-performance over the last few years’.

“So, where would Dr Doom put his money? He likes sugar, cotton and he still recommends accumulating gold, which he expects to continue to out-perform equities for several years. Still, nothing goes up in a straight line, notes Faber, and, therefore, investors need to be aware that gold could still correct to around $750 or so.’

“In Faber’s opinion, ‘the gold bull market will come to an end when Sovereign Wealth Funds – sick and tired of their investments in financial stocks – will finally purchase gold – probably at above $3,000 per ounce.’”

Source: Gwen Robinson. Financial Times – Alphaville, January 3, 2008.

Richard Russell (Dow Theory Letters): Stock market’s primary trend turning down
“Question – Russell, you’ve been talking about a third phase to the stock market. Where are you now on this subject?

“Answer – As you know, I’m guided at all times by the action of the stock market itself. When the market doesn’t agree with me, I stop, revise my thinking – and get in harmony with the market. Which is what I’ve been doing over recent weeks.

“Something has interrupted the major rising trend of the market. It’s not a little thing, no, it’s something very big, very powerful, very basic. Frankly, I don’t know what it is. Could it be that the dollar is in serious trouble? Could it be that the US economy is in chronic trouble? Could it be that the US consumer is finally throwing in the towel on spending? Could it be that the real estate situation is a lot worse than we think? Could it be that the situation is so major that it is beyond the Fed’s ability to manipulate? I don’t know, I honestly don’t know.

“But I do know one thing. The primary trend, the great tide of the stock market, appears to be in the process of turning down.”

Source: Richard Russell, Dow Theory Letters, January 4, 2008.

Asha Bangalore (Northern Trust): Weakness in US labor market points to recession
“The civilian unemployment rate rose to 5.0% in December from 4.7% in November. The December reading is the highest since September 2005. The jobless rate has now risen from a cycle low of 4.4% in March 2007. The increase in the unemployment rate reflects a widespread loss of jobs … Historically, sharp increases in the unemployment rate are associated with recessions.”

Note: Shaded areas denote recessions.
Source: Bureau of Labor Statistics /Haver Analytics

Unemployment Rate and Recessions

“Payroll employment rose only 18 000 in December, the smallest gain since August 2003. Revisions to October and November payroll estimates show a net gain of 10,000 jobs. Private sector payroll employment fell 13 000 in December, the first monthly record of private sector job losses since July 2003. Total payroll employment increases averaged 111 000 per month in 2007 versus a 189 000 per month in 2006. On a year-to-year basis, total payroll employment slowed to a 0.9% gain, down from a peak growth rate of 2.14% in March 2006. Household survey data also show a similar decelerating trend in hiring.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, January 4, 2008.

 

Byron Wien’s Ten Surprises of 2008

Dead on target on the first day of the New Year, Byron Wien again published his annual list of surprises to expect in the coming year. Wien, chief investment strategist of Pequot Capital, has been publishing his list of economic, market and political surprises since 1986.

Reviewing Wien’s 2007 list, he got about half of his predictions right.

He foresaw the surge in agricultural prices, the Fed refraining from reducing interest rates in the spring, and Latin America putting in a good performance. He furthermore predicted gold bullion at $800 and oil at $80 – perhaps too conservative but nevertheless in the right ballpark.

Wien was, however, quite wrong with his prediction of a year-end yield of 5.5% for the US 10-year Treasury Note, as the actual figure turned out to be significantly lower at 4.04%.

Although Wien’s prediction of higher stock market volatility, expecting a year-end VIX Index of 20 (compared with the actual value of 22.5) was on target, his other stock market predictions were off the mark. He expected the S&P 500 Index to be 1 600 by the end of 2007 and the Japanese Nikkei 225 Average to gain 15% during the course of the year. Both turned out off the mark – the S&P 500 Index closed the year at 1 468 and the Nikkei declined by 11.1%. Wien also erred with his prediction of S&P 500 earnings growth of 10% – the final number was closer to zero.

Wien believes his ten surprises have at least a 50% chance of occurring at some point during the year. Although this is not a very high probability, his predictions nevertheless make for interesting reading. His list for 2008 is as follows:

1.	In spite of Federal Reserve easing, and other policy measures, the United States economy suffers its first recession since 2001 as housing starts stay soft and banks are reluctant to lend to anyone where a whiff of risk is apparent. Federal funds drop below 3%. The unemployment rate moves definitively above 5% and consumer spending is lackluster.
2.	Standard and Poor’s 500 earnings decline year-over-year and the index drops another 10%. Energy and materials stocks hold up relatively well in what is viewed as a correction rather than a bear market. Market conditions start to improve during the summer.
3.	The dollar strengthens in the first half reaching US$1.35 against the euro and weakens in the second exceeding US$1.50. The European Central Bank begins an accommodative monetary policy. Foreign investors flock in to buy cheap assets in the US early in the year but the dollar declines later as several countries holding large reserves diversify into other assets.
4.	Inflation rises above 5% on the Consumer Price Index as higher commodity prices and oil finally begin to have an impact in spite of modest wage increases. The 10-year US Treasury yield rises to 5%. Stagflation becomes a frequent presidential campaign and Op-Ed discussion topic.
5.	The price of oil goes down early in the year and up later, sinking to US$80 a barrel in the first half as western economies slow and inventories are drawn down, and rising to US$115 in the second. Established wells continue to decline in production while China, India and the Middle East increase their consumption.
6.	Agricultural commodities remain strong. Corn rises to US$6 a bushel and cotton to US$0.85 a pound. Gold reaches US$1 000 an ounce as disillusionment with paper currencies spreads across Asia.
7.	The recession in the United States slows the Chinese economy modestly but its stock market declines sharply. Investors recognize that paying biotechnology stock multiples for highly cyclical companies doesn’t make sense. The Chinese revalue the renminbi by another 10% to control inflation and as a gesture to foreign governments participating in the Olympic Games who complain that Chinese terms of trade are unfair. Several long distance runners refuse to compete in certain Olympic events because of continuing air pollution problems.
8.	The new Russian President Dmitry Medvedev, under the tutelage of Vladimir Putin, becomes more assertive in world affairs. He insists that Russian oil and gas be paid for in rubles and demands a Russian seat at major world conferences. Russia and Brazil stock markets lead the BRICs. The Gulf Cooperation Council markets begin to attract interest among emerging market investors.
9.	Infrastructure improvement becomes an important election theme for both parties and construction and engineering stocks rally in anticipation of huge programs beginning after the new President’s inauguration. Water becomes a critical problem world-wide and desalination stocks soar.
10.	Barack Obama becomes the 44th President in a landslide victory over Mitt Romney. With conditions in Iraq improving, the weak economy becomes the determining issue in voters’ minds. They want to make sure that gridlock ends and Congress gets something done for a change. The Democrats end up with 60 Senate seats and a clear majority in the House of Representatives.

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Investment strategy: guidelines from 2007′s performance

2007 ended with a nasty hangover in the case of some asset classes and stock market sectors, but also with pockets of splendid performance. Reviewing the past year’s investment returns makes for interesting reading, but also provides guidelines in some instances of what to expect in the year ahead.

In order to glean the macro view of what transpired last year, it is useful to consider the performance of the principal asset classes as a point of departure. I have deliberately kept the commentary rather brief as the detailed reasons for specific movements have already been covered in my weekly “Words from the Wise” article.  

Source: Stockcharts.com

Commodities (+16.7%), in general, were the top-performing asset class, followed by the US 10-Year Treasury Note (+4.9%) and the S&P 500 Index (+3.5%). A money market investment, based on the average US 3-Month T-Bill rate, would have yielded a return of 4.4% – somewhat better than the S&P 500 Index (but less than the Dow Jones Industrial Index and the Nasdaq Composite Index as shown later in the article).

The other side of the coin saw the Dow Jones REIT Index declining by 19.2% and the US Dollar Index by 8.4%. The dollar weakness was naturally one of the factors contributing to the strength in commodities.

Interestingly, the performance table changed around quite dramatically during July 2007 as the subprime problems started to surface, resulting in an acceleration of the US dollar’s downtrend and large-scale switching from stocks to bonds and commodities.  

Source: Stockcharts.com

Zooming in on stock markets, the chart below shows the Dow Jones World Index gaining 8.4% during 2007. Top-notch performance was achieved by emerging markets (+28.8%), and specifically by China (+110.1%), India (+69.4%) and Hong Kong (+39.4%). On the other end of the spectrum, Japanese stocks (-5.5%) were in the doldrums and experienced losses.

As far as the major US stock markets are concerned, the blue-chip Dow Jones Industrial Index gained 6.4% – somewhat better than the S&P 500 Index’s 3.5%, but behind the technology-heavy Nasdaq Composite Index’s respectable 9.8%. US small caps, as represented by the Russell 2000 Index, fared poorly in the light of being more sensitive to an economic slowdown and depreciated by 2.8%.

Click here for the detailed performance figures, ranging from one month to three years, for 55 global stock markets.

Looking in some more detail at the various US stock market sectors, seven out of the nine sector SPDRs recorded gains, whereas the Consumer Discretionary SPDR (-14.0%) and Financial SPDR (-20.0%) were the big losers. This weakness was offset by Energy (+36.1%), Materials (+21.5%), Utilities (+17.0%) and Technology (+15.4%), resulting in the major US indexes still ending the year in positive territory.  

Source: Stockcharts.com

The stark difference in performance between the diamonds and dogs are illustrated clearly by the graph below comparing two of the top-performing industries – Oil Services (+50.9%) and Gold & Silver (+21.8%) – with three of the worst casualties – Housing (-38.9%), Banks (-24.6%) and Retail (-17.9%). The subprime fallout, needless to say, stands largely to blame for this dismal performance.

Source: Stockcharts.com

The credit crunch resulted in interest rates declining across the spectrum of the yield curve but to a larger extent on the short end, resulting in a steepening yield curve as shown in the diagram below. As the credit situation deteriorated, safe-haven buying resulted in yields of government bonds being pushed down across the globe. 

Source: Stockcharts.com

The US dollar’s downward trend intensified as the implications of the subprime debacle started to unfold, resulting in the US Dollar Index losing 8.4% during the course of 2007. The largest beneficiary of the dollar’s woes was the euro with a gain of 10.6%.

Source: Stockcharts.com

On the commodities front, oil (+52.3%) was the star performer on the back of a tight demand/supply situation and omnipresent geopolitical tension. Agricultural commodities (+41.1%) also shined as producers battled to keep up with increasing demand.  

The precious metals complex benefited from the Fed’s easier money policy and mounting concerns about rising inflation. Industrial metals, however, were the odd one out and faced declining prices as investors started factoring in slower economic growth.

Source: Stockcharts.com

The overriding message of the above analysis is the strong emphasis on defensive asset classes and sectors. There also does not seem to be any indication of last year’s primary trends reversing as we enter 2008, although some of 2007′s laggards may bottom out during the course of this year.

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Gold glitters brightly at start of 2008

Waving the old year goodbye with a few new records under the belt is no mean feat, but the real glitter for gold bullion is that most indicators seem to point to more good news down the line.

The first record is that the gold price recorded its first ever month-end close above $800 on Monday, December 31. As mentioned in my blog post “Gold bullion – a belated Christmas gift” (December 27, 2007), gold had only closed above this level on two days during its 1980 surge, namely: $830 on January 18 and $850 on January 21. However, the end of January 1980 saw the price significantly lower at $659.

Looking at monthly averages, January 1980 was $675. This figure was equaled in May 2006 and exceeded for the first time in April 2007. A new record of $806 was established in November 2007, whereas December’s average was slightly lower at $802. 

It is, of course, true that in inflation-adjusted terms the gold price is still a long way off its euphoric days of 1980. If adjusted for movements in the US consumer price index, the $850 record would today be around $2 250 and the average for January 1980 around $1 790.

Real gold price^* (January 1971 to October 2007)

^*Monthly averages revalued to Q3 2007 prices. (Gold price deflated by seasonally adjusted US consumer price index.)
Source: World Gold Council

More importantly, the gold price is not only making headway in US dollar terms, but also in most major (and minor) currencies. This is a manifestation of increased investment demand, whereas the initial rise in the gold price from its low in 2001 ($250) until the middle of 2005 was mostly a reflection of US dollar weakness. The World Gold Council reports that identifiable investment demand during the third quarter of 2007 was nearly double year-earlier levels in tonnage terms.

Further to the table published in my previous article, gold has now entered record territory in terms of most currencies other than the US dollar. This includes the currencies of the two largest consumers of gold, namely the Indian rupee and the Chinese renminbi as illustrated below. (China has just overtaken the US as the second largest gold consumer after India, according to the World Gold Council.)

Gold in Indian rupee

Source: Fullermoney.com

Gold in Chinese renminbi

Source: Fullermoney.com

Other central banks pursuing a policy of increasing their gold reserves relative to fiat currencies include Russia and Saudi Arabia. The following charts show the gold price in their respective currencies:   

Gold in Russian ruble

Source: Fullermoney.com

Gold in Saudi riyal

Source: Fullermoney.com

I have debated the fundamental case for investing in gold on a number of previous occasions, but let’s recap the implications of the inflation/deflation scenario by means of an excerpt from Richard Russell’s Dow Theory Letters. (I should add that he has been reading the gold cycle with painstaking accuracy.)  

Russell says: “… the Fed is fighting the potential forces of deflation. What deflation? Deflating home prices, a potential decline in consumer spending, plus the specter of rising unemployment. … let’s say that in 2008 the economy turns ‘bad’. In that case, the Fed will step on the accelerator and fight the downturn with everything at its command, which … means expanding liquidity and declining short rates. … the ideal atmosphere for a rising price of gold.”

Examining the opposite side of the coin, he argues: “Let’s say that the US economy stabilizes. The housing situation hits bottom and begins to improve. Business realizes that the worst is over for banking and housing – the economy is starting to recover. In the face of this, all the Fed’s previous monetary machinations begin to ‘kick in’. Under those conditions, gold is again advancing. All the money that was created during 2007 to counteract recession now acts as an ‘overflowing punch bowl’. The global economy is ‘on fire’. Under these conditions, gold heads sharply higher.”

The one situation that could be bad for gold is when deflation takes over and there is a panic for cash in order to stave off bankruptcy. A variety of assets, including gold, would then be sold in order to raise dollars. But this state of affairs is rather unlikely while central banks are at liberty to create money out of thin air.

I cannot help but conclude that we have not yet seen the last of the yellow metal’s new records and that more excitement lies ahead. For starters, I will not be holding my breath for the all-time high of $850 to be breached. After all, platinum, which often leads gold higher, has already recently recorded an historic high in US dollar.

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Words from the wise for the week that was (Dec 24 – 30, 2007)

This week’s edition of “Words from the Wise” is briefer than most as I must answer the call of family to spend a last few days with them before putting shoulder to the 2008 wheel.

My kids have asked me to help them fly a kite, but the wind seems to be a bit too gusty to achieve this with much success. This makes me wonder how stock markets are going live through the various tailwinds and headwinds that will invariably come to blow during 2008.

In the words of market veteran Richard Russell, author of the Dow Theory Letters: “This market cannot make up its mind. The bullish case is strong, the bearish case is strong, and a lot of very big money is very divide on the outlook for the stock market. Thus – we have a very nervous, high volatility market with the Dow jumping over 100 points (up or down) every other day. It’s enough to give an honest man the ‘willies’.”

And in the spirit of the holiday period, David Galland of Casey Research observed: “… we have the US stock market, which, despite the energetic efforts of government on many levels, is stumbling along like a blind drunk after a long and well-lubricated holiday season party. One minute, Mr. Market has a big happy smile on his face, but the next he’s flat on his face. Struggling to his feet, he is barely able to whisper an ebullient toast before tripping over his own shoes and falling back to the ground.”

I will be watching the market carefully as 2007 fades out and the New Year comes in. The market action during the few days of December and January often provides hints regarding the rest of the year. For example, if the so-called “Santa Claus Rally”, which has one more trading day remaining in 2007 and two more in 2008, does not materialize, it typically is a harbinger of a sizeable correction or bear market in the coming year.

The “January Barometer”, stating that as the S&P 500 Index goes in January so goes the year, will also be watched with more than a cursory glance. 

Furthermore, the best years for stock market gains have been years ending in 5, with the second best years being those ending in 8. Since 1891 there have been only two years ending in 8 that were negative, namely 1948 when the Dow was down 2.1% and 1978 when the index declined by 3.2%.

Here’s wishing you a wonderful New Year. May it be truly joyful and exceptionally rewarding on all fronts.

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the market’s ups and downs on the basis of economic statistics and a performance chart.

Economy
The assassination of Benazir Bhutto, Pakistan’s former prime minister and opposition leader, weighed heavily on markets during the past week, raising the possibility of instability in a volatile region.

An international crisis could not have appeared at a worse time with the global financial system appearing to be an unpredictable black hole. Also, further evidence of worsening economic conditions came in the form of new home sale tumbling by 9% in November to the slowest pace in 12 years and durable goods orders rising a disappointing 0.1% in November. More reassuring data on US mid-west manufacturing activity were largely brushed aside.

All this was piled on top of mounting concerns about more banking write-downs, rising inflation and a deteriorating outlook for economic growth. 
 

Date	Time (ET)	Statistic	For	Actual	Briefing Forecast	Market Expects	Prior
Dec 26	10:30 AM	Crude Inventories	12/21	-	NA	NA	-7586K
Dec 27	8:30 AM	Durable Orders	Nov	0.1%	4.0%	2.2%	-0.4%
Dec 27	8:30 AM	Initial Claims	12/22	349K	345K	340K	348K
Dec 27	10:00 AM	Consumer Confidence	Dec	88.6	87.5	87.0	87.8
Dec 27	10:30 AM	Crude Inventories	12/21	-3299K	NA	NA	-7586K
Dec 28	9:45 AM	Chicago PMI	Dec	56.6	52.5	52.0	52.9
Dec 28	10:00 AM	Existing Home Sales	Nov	-	NA	NA	4.97M
Dec 28	10:00 AM	New Home Sales	Nov	647K	700K	715K	711K

Source: Yahoo Finance, December 28, 2007.

The next week’s economic highlights, courtesy of Northern Trust, include the following: 

•	Existing Home Sales (Dec 31) – Sales of existing single-family homes are down 31.0% from their peak in September 2005. The consensus is for a steady reading in November. Consensus: 4.97 million.
•	ISM Manufacturing Survey (Jan. 2) – The Manufacturing ISM survey for December is predicted to fall to 50.3 form 50.8 in November. Indexes tracking new orders, production and employment should be market movers. The employment index fell to 47.8 in November. Consensus: 50.3 from 50.8.
•	Employment Situation (Jan. 4) – Payroll employment in December is predicted to have risen 40,000 after a gain of 94 000 in November. The gradual upward trend of initial jobless claims suggests that hiring was probably slow in December. The unemployment rate should have risen to 4.8% in December following three monthly readings of 4.7%. Consensus: Payrolls +65 000 vs. +94 000 in November; unemployment rate – 4.8%.
•	Other reports - Construction Spending (Jan. 2), ISM Non-Manufacturing Survey, and Factory Orders (Jan. 3).

Markets
The performance chart obtained from the Wall Street Journal Online indicates how different global markets fared during the past week. 

Source: Wall Street Journal Online, December 30, 2007.

US stock market indexes declined modestly during the past week on the back of increasing economic woes and worries about the situation in Pakistan. The worst casualties were REIT stocks (-2.1%), small caps (-1.8% in the case of the Russell 2000 Index) and financials (-1.2%). Energy (+1.4%), however, brought investors some joy.

The MSCI World Index recorded a gain of 1.1% for the week as a result of the strong performance of emerging markets (+2.6%), and also a small positive contribution from the Japanese Nikkei 225 Average (+0.3%).

On the currency front, the US dollar had its worst week in a year as the poor economic statistics increased expectations of more interest rate cuts, resulting in the US Dollar Index declining by 2.0%. Similarly, sterling hit its lowest level in one-and-a-half years against a basket of currencies after a report of slower growth in house prices raised expectations of interest rate cuts early in 2008. On the positive side, the euro, the Swiss Franc and Chinese renminbi increased strongly.

As far as money markets were concerned, the three-month dollar Libor rate eased to its lowest level since February 2006 and the three-month euro rate was set at its lowest level since November 22. Government bond yields declined during the course of the week, benefitting from more safe-haven buying.

The oil price came within sight of its all-time high after US fuel inventories fell more than expected and in reaction to tension in Pakistan and northern Iraq. Gold, fulfilling its role as a safe-haven investment in times of political uncertainty and a hedge against inflation, jumped by 3.4%. Silver (+2.8%) was in hot pursuit, but platinum (+0.3%) lagged somewhat after having hit a record on Thursday.

Although agricultural and base metal commodities experienced some profit-taking, the Dow Jones-AIG Commodity Index still managed a 1% gain for the week.

Now for a few news items and some words (and graphs) from the investment wise that will hopefully assist to make sense of financial markets’ shenanigans during the shortened week ahead.

John Carney (Dealbreaker): Why Bhutto’s assassination is very bad news
“The reason it’s terrible news is that Bhutto was actually a source of stability for the country. She was a reasonable and relatively US-friendly alternative to Musharraf. With her out of the picture, it’s unclear what direction the opposition to Musharraf will take. But what is clear is that the opposition will most likely strengthen and act with a greater sense of urgency. The world is slightly more dangerous this afternoon than it was when we went to bed last night.”

Sources: John Carney, Dealbreaker, December 27, 2007 (text); and Bloomberg, December 27, 2007 (photo).

ABC News: US checking al Qaeda claim of killing Bhutto
“While al Qaeda is considered by the US to be a likely suspect in the assassination of former Pakistani Prime Minister Banazir Bhutto, US intelligence officials say they cannot confirm an initial claim of responsibility for the attack, supposedly from an al Qaeda leader in Afghanistan.   

“An obscure Italian Web site said Mustafa Abu al-Yazid, al Qaeda’s commander in Afghanistan, told its reporter in a phone call, ‘We terminated the most precious American asset which vowed to defeat [the] mujahedeen.’ It said the decision to assassinate Bhutto was made by al Qaeda’s No. 2 leader, Ayman al Zawahri in October. Before joining Osama bin Laden in Afghanistan, Zawahri was imprisoned in Egypt for his role in the assassination of then-Egyptian President Anwar Sadat.

“Bhutto had been outspoken in her opposition to al Qaeda and had criticized the government of President Pervez Musharraf for failing to take strong action against the Islamic terrorists. ‘She openly threatened al Qaeda, and she had American support,’ said ABC News consultant Richard Clarke, the former White House counterterrorism adviser. ‘If al Qaeda could try to kill Musharraf twice, it could easily do this,’ he said.”

Source: Brian Ross, Richard Esposito and R. Schwartz, ABC News, December 27, 2007.

Times Online: Main Bhutto suspects are warlords and security forces
“The main suspects in the assassination are the foreign and Pakistani Islamist militants who saw Ms Bhutto as a Westernized heretic and an American stooge, and had repeatedly threatened to kill her.

“But fingers will also be pointed at the Inter-Services Intelligence agency, (ISI) which has had close ties to the Islamists since the 1970s and has been used by successive Pakistani leaders to suppress political opposition. Ms Bhutto narrowly escaped an assassination attempt in October, when a suicide bomber struck at a rally in Karachi to welcome her back from exile.

“Ms Bhutto said after the attack that she had received a letter, signed by someone claiming to be a friend of al-Qaeda and Osama bin Laden, threatening to slaughter her like a goat. But she also accused Pakistani authorities of not providing her with sufficient security, and hinted that they may have been complicit in the Karachi attack.”

Source: Jeremy Page, Times Online, December 28, 2008.

 

Investment recommendations for troubled times

I read a great many reports from investment strategists and other market gurus, but a firm favorite always remains Donald Coxe, Global Portfolio Strategist of BMO Financial Group. I largely share Donald’s investment recommendations as published in the December edition of Basic Points, entitled “Double, Double, Greed and Trouble, CDOs and Housing Bubble”, and have therefore thought it appropriate to republish these eloquently written paragraphs below.

1.	Remain heavily underweight banks, particularly investment banks that have displayed monumental stupidity. Do not assume that a change at the top will automatically convert them into temples of wisdom (unless it is accompanied by demands for the departing to repay bonuses based on bets that turned out disastrously). Better to assume that, like subprime-based DOs, there are layers of rot that can make the entire product dangerous to your financial health.
2.	Remain overweight Emerging Markets, emphasizing those that are oil, gas, and/or food exporters.
3.	Soaring food costs threaten stability for some Third World economies. We have been ardently endorsing India since we returned from our leave of absence a year ago. We are now more cautious, because a weak monsoon could be politically and economically destabilizing at a time of $4 corn and $10 wheat.
4.	Remain heavily overweight gold – both stocks and the ETF. Gold is almost as good a protection against banking problems as SKF – the UltraShort Financials ETF – a security which may not be a suitable investment in some portfolios.
5.	We continue to believe that the Agricultural stocks are the pre-eminent investment class of our time. Farm incomes are rising rapidly and, in the US, farms and farm land are the real estate assets that are rising in value and are virtually immune to foreclosures. That means the leading Ag companies have great pricing power and minimal credit problems. We now hear suggestions that because food inflation has finally made it to the cover of The Economist, it is time to start moving toward the exits. Not so: We think that fine cover story could be the atonement – At Last! – for the magazine’s famous 1999 cover: $5 Oil.
6.	Remain overweight oil and gas producers, including the Alberta oil sands producing companies. As disappointed as we are with the new royalty schemes in that province, Alberta certainly remains more attractive than Nigeria or Angola – and much more attractive than Russia, Kazakhstan or Venezuela.
7.	We think it is time to begin accumulating the refiners that are equipped to handle heavy high-sulfur crude. The collapse of the crack spread has savaged refiners’ earnings, but that will eventually rebound. The Saudis have virtually turned out the Light, and less and less of the oil that the Gulf states will be lifting will be of the most desirable grades.
8.	Retain the base metal stocks that have long-life unhedged reserves in secure areas. Even if there is a global recession caused by global collapses of subprime paper and LBO loans, it will not be deep enough to drive base metal prices back to 2004 levels – but would be worrisome enough to push further mine development even farther into the future.
9.	When borrowing, borrow where possible in dollars. When investing, invest where possible in other currencies.
10.	Stagflation is a bad backdrop for bonds – and for non-commodity stocks. The central bankers could have headed it off had Wall Street behaved with a modicum of morality, but the Fed and its brethren are forced into sustained reflation because of the global solvency crisis. Corporate earnings for most sectors will not meet current optimistic Street forecasts, and rising inflation will reduce the market’s P/E.

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Gold bullion – a belated Christmas gift

I am spending a few days of the Christmas break at a village alongside the coastline of the Cape Town Peninsula. It is quaint, picturesque and simply an ideal location for enjoying quality time with the family. The only drawback is that it does become quite windy on occasion – at best not a highly predictable event. This reminds me of the erratic behavior of gold bullion – you just never know with what action the yellow metal is going to surprise you next, making it infamously difficult to predict short-term movements.

And true to form, just as traders were bargaining on a quiet Christmas period, gold again startled with a $15 jump, taking the price well clear of the $800-level. (The rally commenced more than a day prior to the assassination of former Pakistani Prime Minister Benazir Bhutto.) Interestingly, gold has never in its history recorded a month-end price above $800 and only closed above this level on two days during its 1980 surge, namely: $830 on January 18, 1980, and $850 on January 21, 1980. That, however, represented a blow-off with the price plunging to $737.50 a day later and falling further to $659 by the end of January.

It would seem that gold bulls may very well have reason to toast bullion next week, saying goodbye to 2007 having achieved the $800 month-end milestone. There is, however, quite an important difference between 1980 and the present situation. In 1980 gold was in a parabolic rise, whereas since the low of $250 in 2001 gold has been rising methodically, mapping out consistently higher lows as shown below.

Source: StockCharts.com

The upside breakout from the pennant consolidation pattern is a bullish technical development and looks well supported by the rising momentum (top section of graph) and MACD (bottom section of graph) indicators.  

The gold price has not only strengthened in US dollar terms, but has in fact been appreciating in most currencies – an indication of increased investment demand. The following graph and table (not yet reflecting the post-Christmas rally) clearly illustrate this phenomenon.

Source: Plexus Asset Management (based on data from I-Net)

GOLD PRICE MOVEMENTS IN VARIOUS CURRENCIES
Gold price in various currencies	2005	2006	2007 (YTD: Dec 24, 2007)
Gold in US dollar	17.9%	23.1%	27.5%
Gold in euro	34.9%	10.5%	16.9%
Gold in British pound	31.3%	8.3%	26.4%
Gold in Swiss franc	35.9%	14.1%	21.1%
Gold in yen	35.5%	24.4%	22.5%
Gold in Aus Dollar	24.9%	13.9%	16.2%
Gold in Can Dollar	14.0%	23.5%	7.8%
Gold in rand	31.9%	37.1%	27.3%
Gold in renminbi	15.0%	19.1%	20.1%
Gold in rupee	22.7%	20.8%	13.7%
Gold in dinar	17.9%	23.2%	21.1%

Source: Plexus Asset Management (based on data from I-Net)

The pressing question is how sustainable bullion’s uptrend is. Although the technical picture indicates a primary bull market, the fundamental situation offers both bullish and bearish arguments.

The arguments in favor of a rising gold price have been well documented and include: the possibility of ongoing pressure on the US dollar, increasing global inflationary expectations, a surging oil price, minimal new mine production, and the fact that central bank sales are capped through the Central Bank Gold Agreement (CBGA II).

The bears, on the other hand, point to: record long speculator positions that have in the past been strongly correlated with gold price corrections, potentially lower fabrication demand from India (as a result of the higher price), and a slowdown in producer de-hedging as the global hedge book diminishes. Additionally, a seasonally weak period is approaching from February to April as illustrated by the graph below.

I have over the past few months often conveyed my bullish stance on gold bullion. Examples of these articles include: “Gold: forwards and upwards” (September 14, 2007) and “Smart money bets on surging gold price” (September 4, 2007). I see no reason to change this position, from both an absolute and safe-haven point of view. I would, however, caution that one should not chase a surging gold price in an attempt to stock up on the various gold-related instruments. Rather bide your time and wait for the short-term corrections that occur regularly, perhaps coinciding with the advent of seasonal weakness in a few weeks’ time.

The final word goes to George Bernard Shaw who said: “The most important thing about money is to maintain its stability… You have to choose between trusting the natural stability of gold and the honesty and intelligence of members of the government. With due respect for these gentlemen, I advise you, as long as the capitalist system lasts, to vote for gold.”

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